Wednesday, August 19, 2009

Modelling Fannie Mae and Freddie Mac – Part VI

This is the money post. I put Parts I, II, III, IV and V together to come to the surprising conclusion that both Fannie and Freddie survive. This conclusion is highly-non-consensus and has substantial political and investment implications. Also I would like to thank FTAlphaville for linking to this series – most the rest of the blogosphere has been silent possibly because I disagree with their preconceptions/ideology. The comments on FTAlphaville reflect mainstream finance opinion – that Fannie and Freddie are irredeemably insolvent.

Putting the model together

We now have enough to do some basic modelling of Fannie Mae and Freddie Mac. I will do it for Freddie Mac only – and leave it to the more ambitious readers to do it for Fannie Mae.*

In the second post in this series I demonstrated how the losses that have been booked to date (rather than provisioned to date) have come primarily from outside the traditional guarantee book of business. Those losses are primarily mark-to-market losses on mortgage securities (especially subprime securities), mark to market losses on the hedge book and the write-off of tax assets.

None of those loss categories are going to expand – and indeed some will reverse.

In the fourth post I estimated the losses in the traditional guarantee book of business. I have asserted that the model is fairly robust (and will cover that in the next three posts) however I showed under quite reasonable assumption that there were $37.6 billion in losses to be realised at Freddie Mac at year end 2008. Since then $2.9 billion have been realised so there are $34.7 billion left to come.

Of these losses 25.2 billion have already been provided for. From now until when the problem-years of business loans run off Freddie will only need to take another 12.5 billion in provisions. They may elect to take more than $12.5 billion in provisions – but if they do and my models are reasonable – then in all likelihood the excess provisions will be reversed through the income statement.

Now if you go to the last Freddie Mac results you will see they have a positive net worth of $8.2 billion. However they owe the government $51.7 billion, as the government has injected $51.7 billion in senior preferred securities. They are thus $43.5 billion in the hole.

They will also – over time – take another $12.5 billion in provisions. So now, until all the problem years of business have run off, they will be $56 billion in capital short.

The Government can get its money back on their “investment” in Freddie Mac provided Freddie can earn more than $56 billion over a reasonable time period and meet the government interest charges.

This would be more certain if some of the losses described in Part II reversed. I am pretty sure that they will – but lets ignore them (until a later post). Pre-tax, pre-provision operating profits of Freddie Mac are running at over $15 billion. If the government were not demanding 10 percent on its preference shares the companies would be sufficiently well capitalised to repay their interest in 4 years. With the drag of having to pay the government $5 billion per annum it will take a bit over five years. Either way the operating profits of Freddie Mac are big enough to ensure the government gets its money back. If you do the same analysis for Fannie Mae its is even better. However Fannie has less aggressively marked private label securities to market so it has less chance of recoveries from their current marks. The consensus view that the GSEs are forever toast – and forever a drain on the US Government is very likely wrong.

Implications

I have tried modelling this half a dozen ways and the result is fairly robust. If anything the GSEs (especially Freddie) are solvent quicker than the model I have presented suggests. Indeed if the tax losses are allowed to be bought back as capital they will reach solvency a year and a half earlier – and will be in the position to repay substantial government money during 2012.

The losses (even after all losses are booked) come from primarily outside the traditional business of guaranteeing small well-secured and documented mortgages.

Traditional GSE business (guaranteeing lower value mortgages with reasonable terms on full documentation and with a down-payment) was very effective at raising home-ownership rates whereas modern subprime lending, it seems, just caused a blip in home-ownership rates that corrected with much pain. Later in this series I am going to go through the politics of this issue. However for now it suffices to say that by the time Obama is up for re-election the Government will be in a position to ask for and receive considerable repayment from the GSEs. One of the festering sores from this crisis will appear healed.

One more implication for my investor readers (and this after all started as an investment blog). If the GSEs can repay their debt to the government – and I think that they can – then the common stock in both companies has value. That is a non-consensus view. However the real value is in the preferred securities.

The preferred securities are currently trading between 4 and 6 cents on the dollar (and went down whilst I was writing this sequence indicating my readers either do not believe me, do not have money or had no idea where I was going).

The preference shares are all non-cumulative so you are not entitled to back-coupons when they resume paying – but they will resume paying sometime in the next 4-7 years. At 4-6 cents in the dollar that makes them a real bargain – offering 16 to 25 times your money over 4-7 years. That is a better return than you will get in most places. Even the lower end of the range offers a 50 percent annualised return. The return on the preference shares is substantially better than any possible return on the common stock. However – and it should be noted – the conservatorship agreement gives no time period and specifies no criteria for the government to release Fannie and Freddie for conservatorship. This means that even if this model is right – and Fannie and Freddie do recapitalise internally – there is still no guarantee you will get paid on the preferred. Political risk is omnipresent.

Bronte’s position

At Bronte we have thought that the pre-tax, pre-provision profits were sufficient to recapitalise the GSEs for a while. We purchased large holdings of these securities below 2 cents in the dollar. Eventually the preferreds started rising leading to some financial-press scepticism that they would ever be worth anything. All I can say – at Bronte our money and our client money is where our mouth is.

There are plenty of risks to this rosy hypothesis. These fall mainly into the political risk camp (there are many people who will fight a resurrection of the GSEs). However there is model and economic risk as well. I will examine the risks (model, economic and political) in later posts. The next three posts are (unfortunately) a little disjointed because all I am trying to do is subject my model to different data-tests and see if it is robust. You will find that I am much more comfortable about the credit loss estimates in the model (Part IV) than I am about the income estimate (Part V).

What makes me most uncomfortable though is the political risks – and those I have very little idea how to analyse. Late in this series I will be very keen to see if I can get a robust discussion at Talking Points Memo – because those readers know far more about politics than me or most the regular commentators on my blog. For the moment though what we have is Republicans (and a much smaller number of Democrats) who are extremely keen to put Fannie and Freddie into liquidation now and hence make all of this modelling entirely redundant.

John

*At Bronte we have done the models for both Fannie Mae and Freddie Mac. If the relevant Treasury or NEC officials wish to contact me we will provide our models more generally.

25 comments:

Rod
said...

Re political risk - is there not more political risk should your thesis be correct? i.e. if the GSEs are insolvant then there is incentive to keep them in a zombie state to avoid crystalising the political fall-out from admitting the original plan failed. Conversely should they begin to return to positive value, then the risk turns to perception that private investors are reaping huge profits on the back of a taxpayer subsidy - hence more incentive to liquidate?

But as long as they liquidate slow enough I get paid on the prefs - but the common may be near worthless...

But if I am right and they are not zombies then it says something nice about quasi-government finance and something awful about private sector finance. Given I have spent my life in private sector finance that is not entirely comfortable.

I think your political concerns may be unfounded. You need to take into account the fact that the Fifth Amendment to the US Constitution prohibits a taking of private property without the payment of "just compensation" to the property owner.

Contrary to Henry Paulson's view of the world, the government cannot take the liberties or extract the spoils of a corporate raider in its dealings with the GSEs. The junior preferred stock cannot arbitrarily be wiped out by political action without compensation to the holders, and, if your analysis is correct, the preferred should be money good in an orderly liquidation or sale.

The dividends present an even more serious issue for the government.

Since they are not cumulative, each dividend passed will never be paid. The exercise of control by the government to prohibit payment of these dividends, while paying itself a 10% return on the senior preferred it negotiated with itself, also has all the elements of a taking.

While there might be valuation arguments with respect to compensation for a taking of the preferreds themselves, the only "just compensation" for taking of a fixed dividend is the dividend.

The statute of limitations on taking actions against the government is 6 years and I have no doubt suits will come long before that if this administration does not take positive action soon.

In the UK, government officials have suggested legislating to limit mortgages to a 3x salary multiple, compared to recent mortgages which have been up to 6x unproven income. Doing this overnight would obviously crater the housing market, and cause untold pain, though I haven't seen anyone say that anywhere.

I see parallels with the GSE's in that given they provided a subsidy to US housing, removing that subsidy would cause house prices to fall. If the Republicans want house prices to stop falling, then they have to allow the GSE's to continue to exist.

Perhaps they'll be scaled down in size or gradually phased out, but that would have to be much further down the road.

To the poster who thinks the political concerns are overstated: Where have you been in for the last 6 months. Have you seen how the government dealt with bond holders of GM and Chrysler. The Roberts Supreme Court didn't save them. I think a real analysis of the political risks have to deal with possible scenarios should the Government be paid back, and also should deal with whether the GSE's will be forced to cut standards to support any efforts by the Obama administration to "stabilize housing prices".

Do you agree that your conclusion "Buy preferred stock" is ultimately a bet on a housing recovery sufficient enough to limit total GSE losses to levels that allow these companies to free themselves from the Government liability and return to profitability? I would argue that expressing this housing view via GSE preferreds is suboptimal because it is overly exposed to model risk and political risk. In other words, if you really believe in a housing recovery, aren't there simpler or cleaner ways to express this view that don't expose you to such unhedgeable risks? At the end of the day (or five years) you might be totally right about you loss estimates yet lose big on your investment.

The model requires that housing does not get dramatically worse from here - I will go through the sensitivities in the next post.

_

I agree political risk is sub optimal - but I purchased at 1.7 cents in the dollar and they are still only about 4-5 cents in the dollar. The 6000 percent return on my purchase makes the political sub-optimality something I can deal with.

I have one issue, that bothers me a lot and that is, FNM slavish booking of reserves as a function of NPL's.

If you have a company large as FNM and FRE and peoples ability to pay will show follow the overall economy, but only a minority of delinquent mortgages are underwater with more than 30%.

FNM has 400 BUSD of underwater mortgages, but only 150 or so are 125% or more under water. And only a fraction of those underwater are also seriously delinquent, that is a combined 50 BUSD. Of this some part are credit enhanced, and should cover even underwater mortgages.

It is IMO IMPOSSIBLE to go from adequately capitalized to 50 BUSD in negative equity, in one year, with the book of business FRE and FNM have, and only a 6-15% house prices decline, depending on what index you use.

The dramatic panic could case the huge rice in delinquencies, because you cannot estimate them, but you can, however, quite easily estimate the losses, since you now underwater mortgages, and house price decline.

FNM has 51 BUSD in credit loss reserve, and also has around 15 BUSD in PBT. Still only 3 BUSD is actual charge-offs.

I'm becoming insane with Lockhart and Allison reserve policies, since they force FRE and FNM to make draws that in turn effectively kill these companies.

In other worlds, they are killed not by actual losses, but by the huge build op of reserves for future losses.

I got interested in the prefs. as a result of an offhand comment by Jamie Dimon during the 3Q08 chase call, where he said there might be residual value in them. That said, there have been comments in the news that the administration intends to eventually take the GSE's into govt. ownership, as a quasi-agency like GNMA.

There is an inherent conflict between the goals of a profit-making firm and a govt. agency solely concerned with a well-functioning conforming mortgage market. That's why the GSE's were taken into administration, and why the firms were such a political football beforehand. They kept the private enterprise hat on and at least FNM got their pocket picked by Mozilo.

If the govt. didn't step in the GSE's would have been insolvent. That fact argues against a recovery here. In favor of some recovery is the fact that many banks own the prefs. in portfolio, and took big writedowns. I've had a working assumption that there'll be an exchange offer down the road at 5-10% of face just to help the banks and to reduce a contingent liability.

from bloomberg:"Bernanke has urged Congress to back part of Hoenig’s proposal for dealing with faltering big banks, which would wipe out shareholder equity in any that receive government aid. The Treasury Department’s so-called resolution authority plan, while likely to result in stockholder losses, doesn’t require it."

Well, there is an "agreement", that was forced upon FnF. So first, FnF have written a warrant for 80%, that could be exercised, and they have "agreed" to pay 10% dividend on any draw they make on the facility.

BUT, what do FnF get in return for this? This is a very delicate question. Before C-ship, FnF had a mission and a Charter to follow, and private shareholders to answer to. After C-ship, as far as the forced upon "agreement" are concerned, the Conservator has no possibility to follow a mission or go about business as before. The Conservator got 80% warrants and 10% dividend on draws, BUT, with this also come a strict responsibility to work hard and forcefully NOT to make any draws, and to say NO to everything that could lower assets values. "Conserve and preserve assets and restore to solvency" is the text.

If you look at what the Conservator has done, it is rather the opposite. IMO most people don't realize this.

I'm enjoying the series, and I have long enjoyed your blog. Your case is well laid out and, obviously, well thought out. One thing you don't mention, or if so I have missed it... Fannie and Freddie are still in business, still buying or guaranteeing loans. This is likely to continue, and although the business is likely to perform better, they will still have losses in the future related to loans they have not yet even guaranteed. Is your hypothesis that these future losses on loans originated since the end of your analysis (or loans yet to be originated) is small enough not to matter? I don't know what these losses will be, but it will be greater than 0 and, in the event you are 100% accurate with your scenario, this part would mean that you have overestimated the time period in which Freddie will earn its way out of government ownership. That is to say, it will take longer.

Is this a fair argument? Do the current and future loan originations need to be assessed? I believe (with some justification - for the last few months I have been working in the industry) that the loan quality is significantly higher now than it used to be, but it still will suffer losses.

One way to reduce political risk is to become active in the political process. With the GSEs forced to dismantle their government relations staffs, the shareholders have no voice in Washington. There is a group of Fannie and Freddie shareholders organizing a trade group to educate policy makers on the value of the traditional GSE mission. If you would like to get involved, please contact me.

I believe the truth of my criticism posted on Aug 20th has been borne out. A simple bet such as S&P Case Shiller futures has greatly outperformed gse preferred stock since then. I still believe that if one wants to bet on housing than one should bet on housing: keep it simple.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.